National Seminar on Corporation, Corporate Law
Corporate Governance: Islamic Perspective
14 September 2004
Legal and Shariah Issues in Islamic Capital Market

Nik Ramlah Mahmood

Saudari Pengerusi Majlis dan hadhirin yang dihormati,

Assalamualaikum Warahmatullahiwabarakatuh dan selamat pagi.

On behalf of the Securities Industry Development Centre (SIDC) of the Securities Commission, I wish first to put on record our deepest appreciation to IKIM for inviting us to jointly organize this conference together with the Companies Commission of Malaysia (CCM) and the Malaysian Institute of Corporate Governance (MICG). For the SIDC and SC, it is always an honour and a pleasure to work with highly respected organizations like IKIM, CCM and MICG in areas of common interest.

I would also like to thank the co-organisers for inviting me to share my thoughts on “Legal and Shariah Issues in the Islamic Capital Market”.

Tremendous growth in ICM globally and in Malaysia

There is no doubt that the Islamic Capital Market (or ICM) has evolved and grown to become an increasingly significant component of the global financial market. The growing global demand for and interest in ICM products has spurred its impressive growth over the recent years. Currently, the size of the Islamic equity funds globally is estimated to be approximately USD 3.3 billion, growing at over 25 % annually over the past seven years. The size of Islamic bonds globally is said to be USD 25 billion.

It has often been said that the potential for further growth is tremendous given that 52% of an estimated USD 1.3 trillion wealth of Middle Eastern Muslims are currently not invested in the Islamic financial system. While that is a useful indication, I would however argue that the potential for the ICM is not and must not be limited by the size of the global assets of Muslims, huge though that maybe. After all, the ICM offers ALL investors, Muslims and non-Muslims alike, products that are as innovative and as competitive as those in the conventional products.

Indeed the growing significance of the ICM in the global financial arena has not gone unnoticed by the major financial centres and their respective regulators. In 2002, IOSCO or the International Organisation of Securities Commissions, an organization of securities regulators with over 170 members formed an Islamic Capital Market Task Force to assess the extent of the development and potential regulatory issues relating to ICM as well as to gather information on Islamic financial products and activities. Of particular interest is that membership of this Task Force which is chaired by Malaysia includes major regulators such as those from the United States, Australia, Italy and the United Kingdom, apart from regulators from Muslim countries such as Indonesia, Turkey and Jordan.

The positive global development of ICM is mirrored in Malaysia. The rapid progress of the domestic ICM, reinforced by significant developments in the ICM infrastructure, including of course the legal and Shariah infrastructure and regulatory framework, has strengthened the position of ICM in meeting the funding and investment needs of issuers and investors respectively. As at 30 June 2004, there are 65 Islamic funds with net asset value of RM 5.4 billion and a market share of 7.2%. It is worth highlighting that since 1993, the net asset value these Islamic funds has been growing at a staggerng 47.6%, whilst the total industry grew at 9.6% annually.

The Islamic debt market has also experienced rapid growth since its emergence in the 1990s. The issuance of Islamic bonds has expanded steadily at an average annual growth rate of 33.7% since 1995. As at 30 June 2004, the size of the Islamic corporate bond market is RM 64.3 billion or 36% of the total corporate bond market. In the equities market, 80% of Bursa Malaysia’s total listed stocks are classified as Shariah-compliant stocks.

ICM today is therefore a key component of the overall capital market in Malaysia and plays an important role in generating the economic growth of the country. It complements the conventional capital market for capital seekers and providers, and also plays a symbiotic role to the Islamic banking and takaful systems in broadening and deepening the Islamic financial markets in Malaysia.

While much more needs to be done, we are convinced that the strategies for the development of Malaysia’s ICM as articulated in the Capital Market Masterplan has provided the impetus for this remarkable growth.

Key principles and objectives of securities regulation are applicable to ICM and conventional products alike

The Islamic capital market broadly refers to transactions, operations and services within the capital market such as fundraising and investment activities, that comply or are not inconsistent with, the teachings of Islam. Typically, ICM products and services are based on the principles of no financing of haram activities, risk-sharing, materiality (ie. it must relate to a real economic transaction) and no exploitation.

So, how does the regulation of ICM differ from the regulation of the conventional capital market?

From a regulatory perspective, ICM products and services must be offered in a manner that does not compromise the universal goals of securities regulation. This means that conventional regulatory wisdom such as those of IOSCO’s Objectives and Principles of Securities Regulation can and should apply equally to ICM. Thus the three objectives of securities regulation namely the protection of investors; ensuring that the markets are fair, efficient and transparent; and reduction of systemic risk are equally applicable to ICM. Hence a regulatory framework that deters and punishes misleading, manipulative and fraudulent practices and promotes full and timely disclosure and ensure equal and fair access to all participants while ensuring that the impact of any financial failure are swiftly contained, are applicable to both conventional and Islamic capital markets.

Similarly the economic objectives of securities regulation such as facilitation of capital formation and allocation and promotion of healthy competition and efficiency, and prevention of exploitation of ill-informed investors are also applicable in the regulation of both markets.

Ensuring regulatory and Shariah compliance

Therefore for ICM products and services to be acceptable to all investors and issuers, it is absolutely vital that these products and services comply with the universally-accepted tenets of securities regulation – they must provide the same level of protection for investors, be offered within markets that are fair, efficient and transparent and must not be more susceptible to systemic risks then their conventional products. More importantly, they must be offered on terms no less attractive and cost-effective than the conventional products in order to be competitive.

However, as I mentioned earlier, ICM products and services have unique characteristics especially those related to Shariah compliance. Also it must be borne in mind that in subscribing to ICM products and services, Muslim issuers and investors place their trust in the regulatory system and expect the products and services to be true to label. So how does a regulator deal with this challenge? How does a regulator ensure that the broad regulatory goals are not compromised whilst at the same time ensuring products and services offered are Shariah compliant?

Some jurisdictions apply the same set of regulations for product approvals as well as the same standards for intermediaries and other regulated entities, leaving the issue of Shariah compliance to be dealt with strictly through voluntary disclosure. With this approach, the task of ensuring compliance with Shariah is left to the issuers or investors and their respective Shariah committees.

The SC whilst recognizing that there is no need for separate parallel legislation for all aspects of ICM, recognizes that in certain areas streamlining and enhancement of existing regulatory framework is sometime necessary towards meeting the specific needs of ICM products and services. The SC also recognizes that to provide the necessary impetus for the ICM to develop, the issue of Shariah compliance cannot be left wholly to the market. It is for this latter reason that the SC in as early as 1996 established a Shariah Advisory Council (SAC) for the Capital Market, pursuant to its powers under section 18 of the Securities Commission Act 1993. This SAC serves as a single point of reference on ICM, providing guidance to all participants in the Islamic capital market on matters pertaining to Shariah compliance.

A two-tier approach in the regulation of ICM

In order to ensure that the goals and objectives of securities regulation as mentioned earlier are not compromised, regulators often rely on a two-tier approach to regulate the provision of Islamic financial products and services. These products and services must comply with both general conventional requirements (i.e. the first tier) and specific requirements by virtue of being an ICM product (in the second tier).

In the Malaysian capital market for example, under the first tier, issuers of Islamic products be it bonds or unit trust are required to comply with provisions relating for instance, to trust deeds, prospectuses etc. which are applicable across the board. Similarly, Islamic financial intermediaries are subject to the full range of conventional requirements governing their activities such as disclosures of interests in the provision of investment advice and recommendations and the segregation of client monies in trust accounts. Listed Islamic financial intermediaries are also subject to the conventional capital market requirements and disclosure standards derived from statutes and the listing requirements. These are conventional legal and regulatory requirements that do not distinguish ICM products from other products.

However, there are circumstances where, to protect investors and given the nascent stage of the market, the regulatory framework may need more specific checks to ensure that the ICM products and services offered in the market are truly what they claim to be. For this we need a second tier of regulation.

In the second tier, the general regulatory solution has often taken the form of prescribed additional disclosure and transparency requirements. While the regulatory cost of prescriptive regulations of this nature may be more significant than mere disclosure requirements, they are necessary for investor protection and market assurance at early stages of the evolution the Islamic capital market. The ideal is that regulatory intervention would decrease as the market matures and is able to self-regulate.

Often these additional requirements can be added to existing first-tier regulations. For instance the Unit Trust Guidelines apply generally to all unit trust funds but there is an additional section that must be complied with by Islamic unit trust funds. These additional requirements relate to among other things, appointment of Shariah committee or adviser, specific reporting requirements and the appointment of a designated compliance person.

Dealing with restrictive first-tier regulations – The Islamic Securities Guidelines

There are, however, instances where modifications of the first tier regulation are needed to so as not to stifle ICM product development and to accommodate additional second tier requirements. One such example relates to the issuance of Islamic bonds.

SC’s regulatory reach over the issuance of bonds including Islamic bonds is based on the definition of securities in the Securities Commission Act (SCA) 1993 which includes debentures. Debenture is defined in Section 2 of the SCA in a manner which requires the element of evidence of indebtedness of a corporation. The Private Debt Securities (PDS) Guidelines issued by SC in 2000 is therefore based on this. As a result until recently, all Islamic bonds are subject to this Guidelines. This definition limits the issuance Islamic bonds only to those based on the principles of Bai’ Bithaman Ajil, Ijarah and Murabahah only. The Guidelines could not be used for the issuance of Islamic bonds which are based on other Shariah principles that do not represent a debt obligation but represent some kind of equity ownership in the asset or business (e.g. Musyarakah and Mudharabah ). As a result, Islamic bonds were subject to definitional constraints imposed by first tier regulation with the effect of stifling the development of the Islamic bond market.

To remedy this, earlier this year, SC after extensive consultation with the industry, de-coupled Islamic bonds from the definition of debentures. We introduced to the SCA (the first tier regulation), a new term, “Islamic Securities” by way of a prescription order. Based on this, we introduced a new set guidelines namely the Islamic Securities Guidelines Recognizing that certain types of Islamic bonds that may be issued will have features more akin to an equity rather than a debt product, the new Islamic Securities Guidelines require musyarakah and mudharabah bonds to be subject to additional disclosure requirements through the issuance of an information memorandum to prospective investors. This will cover disclosures on the nature of the project or business, the risk profile, future cash flow and other related disclosures. It is hoped that this will have the effect of further developing the Islamic bond market by facilitating the issuance of a wider array of Islamic instruments in Malaysia. Henceforth, the development of Islamic bonds will no longer be constrained by conventional definitions.

Leveraging on our regulatory and Shariah infrastructure to take ICM to the next level of development

Our approach in regulating the ICM, including the creation of a Shariah Advisory Council

at the level of the regulator, our systematic and transparent process in the screening of listed companies to determine those that are Shariah compliant, our requirement for appointment of Shariah advisors or consultants as well as specific additional disclosures for Islamic funds and bonds and the various guidelines we have introduced for the regulation of ICM have gained international recognition. So has the experience and expertise that the industry has developed over these years. The overwhelming interest shown by both conventional and ICM international investors in Malaysia’s Global Sukuk two years ago, the increasing involvement of our scholars and other professionals in the global ICM arena and the growing body of literature on the Malaysian ICM in international journals are badges of recognition bestowed on us that we should not take lightly. While there has and will always be differing views on Shariah issues, our approach in the regulation of ICM is increasingly gaining attention if not acceptance as global best practice. For instance there have been articles in international Islamic journals about some of guidelines and practice notes that we have introduced. Increasingly also we have been asked to share our experience in this regard at international fora. Indeed Malaysia’s chairmanship of the Islamic Capital Market Task Force in IOSCO is a clear indication of the level of recognition given by the securities regulators of the world of Malaysia’s achievements in this regard.

It is therefore important that we leverage on these achievements and recognition to take our ICM to its next level of development.

For instance we have in Malaysia the highest number of Shariah compliant stocks with a fully developed screening process. There is at the same time increasing demand world-wide for Socially Responsible Funds or Investments (SRI). These funds basically are also based on similar screening process. The inclusion or exclusion of stocks in the investment portfolio are determined on ethical, social and environmental grounds. Hence there are common features between SRI funds and Shariah compliant stocks because the latter may qualify as socially responsible in that they do not involve alcohol, gambling, tobacco and firearms. The industry could identify opportunities offered by these similarities and adjust their marketing strategies accordingly.

Additionally, IOSCO’s Task Force on Islamic Capital Market in their survey of the global market found that there is an inadequate supply of Islamic capital market products and services offered to satisfy the different needs of issuers, investors and other market participants. The effect is that there is a demand-supply mismatch which results in a higher cost to investors who are interested in the ICM products and services. If I may add the demand-supply mismatch is not just with respect to the products, but more importantly, with respect to the relevant expertise. Given the experience that we have and the expertise that we have developed, Malaysian ICM participants must move quickly into the global ICM arena to take advantage of this mismatch by offering new and more innovative products that are universally acceptable.


The Malaysian ICM has achieved significant growth over the years given the relentless efforts of the government, the industry, the scholars and the regulators. With a facilitative regulatory framework and a core group of experts in place, it is ready to move on to the next plane, and that is to offer more products and services that meet not only the risk-reward appetite but more importantly address all the Shariah concerns of all investors in the international market place.

In the process we will of course encounter differences of opinion and interpretation with respect to the Shariah. In this respect not being a Shariah scholar, I can do no better than to quote the words of Tun Dr Mahathir in his Keynote Address at an international Islamic Capital Market conference organized by the SC two years ago. He said (and I quote):

Of course there are bound to be differences in views and opinion among scholars with respect to the interpretation of the Shariah. This however should not be a cause for paralysis and an excuse for inaction. Rather it should be regarded as both a challenge and an opportunity – a challenge because differences in views will call for deeper analysis and evaluation, and an opportunity because it allows for the vigorous exercise of ‘ijtihad’ among the scholars and the flexibility to test new grounds.

On that note, I thank you for your attention.